Amazon’s Earnings: Visibility On Profit Margins Needed To Lift Stock

The largest online retailer, Amazon (NASDAQ:AMZN) is due to report its first quarter earnings on April 25. The company had a good 2012 with revenues growing to $61 billion, up 27% year-over-year. Most of its sales growth was driven by the strong sales of electronics and other general merchandise across geographies. Operating margins as a percent of consolidated sales improved to 3.2% from 2.7% a year ago.

The primary factor behind the performance was the success of third party sellers on Amazon’s marketplace. However, the company recently hiked the fees it charges third-party sellers for using its services. This led to some discontent and competitor eBay (NASDAQ:EBAY) latched on to the opportunity simplifying its pricing structure. However, benefits like fulfillment services and exposure to a large user base will keep Amazon Marketplace an attractive proposition for sellers. We look forward to the company’s estimates of the impact of these recent activities if any. Also, aggressive pricing cuts from Google and Microsoft for their cloud services has resulted in the company following suit. We will look for any impact on its operating margins because of these cuts.

Amazon competes primarily with leading retailer Wal-Mart (NYSE:WMT), consumer electronics giant Best Buy (NYSE:BBY) and eBay‘s (NASDAQ:EBAY) Marketplaces in the electronics and general merchandise market, Apple (NASDAQ:AAPL) in the tablet device market and Netflix (NASDAQ:NFLX) and Barnes and Noble (NYSE:BKS) in the content market.

The popularity of cloud computing and its profit making capacity has resulted in old IT behemoths such as Microsoft, Oracle, Google, etc. launching new products in the domain. In order to gain market-share from Amazon Web Services, the leader in the market, these companies have indulged in aggressive pricing. Amazon on its part has matched or maintained its prices lower than the former’s prices for similar services. [1]

We expect this to result in margin erosion, and we will look for the impact on the company’s overall margins. As Amazon’s primary revenue generating businesses, online retail and Kindle hardware, are run on razor thin or marginally negative margins, we estimate Amazon Web Services to be the primary profit generator for the company.

The unreliability of Amazon’s East Coast Data Center has blemished its reputation as a web services provider. The latest major incident had resulted in Netflix’s outage on Christmas Eve 2012. These breakdowns could negatively impact the growth Amazon’s cloud services business witnessed in the recent past and result in a slowdown in Amazon’s Web Services revenue growth.

Hike In Seller’s Fee Won’t Impact Retail Sales

Amazon’s gross margins improved from 22.4% in 2011 to 24.8% in 2012 due to the success of third party sellers on Amazon Marketplace. As of Q4 2012, there were more than 2 million worldwide active seller accounts on Amazon and seller units represented about 40% of total paid units, which represents growth of around 3 percentage points. In contrast, the overall unit growth rate for the quarter was only 32%.

However, a series of fee hikes over the past year and a half alienated many merchants with some threatening to defect. Primary competitor, eBay, latched onto the opportunity by simplifying its fee structure to win over these sellers. However, we believe that other benefits like fulfillment services, free listing for pro sellers, exposure to a large user base and attractive free shipping for buyers in the form of Amazon Prime will keep Amazon Marketplace an attractive proposition for sellers. Hence, we expect Amazon’s retail sales to keep growing at rates similar to those in 2012.

Watch For Impact Of Ongoing Kindle Store Expansion On Media Revenues

We will also look for the impact of Kindle Store’s expansion into China and Brazil on Amazon’s media revenues. The company had announced the launch of these stores towards the end of the fourth quarter. We expect positive impact from these store launches on account of the size of these markets. The company is also pushing for the launch of its Appstore in new markets. It recently announced that that developers can now submit their apps for distribution in nearly 200 countries. These apps will be made available in the coming months when the Amazon Appstore for Android launches internationally. The large-scale Appstore launch, push towards acquiring new content for the Amazon Instant Video and launching own content in the form of television series could see the short term margins being negatively impacted on account of associated costs but is expected to drive growth in media revenues in the long term.

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